Cash is king in India, or at least it was. In one single sweep Narendra Modi just scrapped two high-value bank notes in the Indian economy in an all-out war to flush out black money, fight tax evasion and eradicate counterfeit notes that were being used by terrorists. Now the two highest-denomination notes, which account for 86 percent of the value of cash circulating in India, cannot be used for purchases (with very few exceptions) and have to be deposited or exchanged in banks by the end of the year. After that, these notes will turn into worthless pieces of paper. The idea is that forcing people with large piles of cash to bring the notes in will allow authorities to investigate the origins of these fortunes (legal or otherwise).
So to cut to the chase, how effective will demonetisation be in cleaning up ill-gotten gains? By now, it is common knowledge that money received from illicit tax-evading activities is mostly parked in real estate, gold, stocks and, most of all, in foreign bank accounts. One analysis in financial press suggests that only 5 percent of black money in India is kept in hard cash.
That said, perhaps we should take a step back and recognise that this effort is not intended to be the final nail in the coffin against a parallel economy, which is estimated to be in the order of 20 to 40 percent of official GDP! Nor was it meant to put a lid on future creation of black wealth. Rather, it is the first step in a longer-term vision to create a cash-less economy characterised by digitisation and higher financial sector efficiency where the honest man feels good about working productively and paying taxes.
That brings us to the manner of implementation. To some extent, the Indian prime minister adopted Harvard Professor Kenneth Rogoff's suggestion. In his latest book “The Curse of Cash”, professor Rogoff advocates demonetisation of high-value notes to fight corruption and tax evasion. Although his proposal differs from Modi's agenda in terms of implementation: he argued for a gradual exercise (as opposed to a sudden reform) and complete elimination of large notes (instead of exchanging them).
Consistent with Professor Rogoff's argument that a big-bang approach is severely disruptive to the economy, detractors of Modi's demonetisation drive raise concerns over the collateral damage caused by an overnight shock. Surely the honest citizen, elderly and housewives who live hand to mouth do not deserve to suffer stuck in endless queues in front of banks or ATMs to exchange their notes?
To be fair, the government's rationale that the suddenness was designed to prevent existing hoarders from converting their ill-gotten gains has merit. The alternative, a gradual time-bound plan that tracked large transactions, would have had obvious loopholes. Tax-evaders would have split up their loot into smaller transactions which are harder to trace; or they could have divided their pile of cash among several accomplices to buy other assets.
Another lingering confusion is why the government issued an even higher-value note (2000-rupee) to replace the existing ones, which will undoubtedly render basic transactions ever more excruciating? One argument could be that a tax-evader may try to circumvent the process by whitening only part of his black wealth paying the enforced tax and a penalty, withdraw it from the bank and then return later on to deposit the rest (or part of the rest) of his old black money while claiming that he is depositing the same legalised money he withdrew earlier. Therein lies the utility of a note new to the financial system, which allows authorities to differentiate between wealth that has gone through the demonetisation-filter and that which has not.
Setting aside the implementation factor, where does this monetary shock leave an Indian economy characterised by one of the largest share of cash relative to GDP in the world? For starters, the common man, enduring extreme hardship from a shortage of liquidity, will almost certainly put off purchases that are not absolutely essential.
That is just the tip of the ice-berg. At a sectoral level, cash-intensive industries like real estate, construction, transportation, gold and jewellery will no doubt feel the pinch of lower consumption demand. Farmers are likely to face difficulties in selling freshly harvested crops. Micro, small and medium enterprises which operate on cash will, in all likelihood, see their businesses slow down or even come to a grinding halt.
The upshot is an across the board deterioration in major macroeconomic aggregates like consumption, production, employment, GDP growth and tax revenue, at least in the short-run. In fact, analysts of the Indian economy expect demonetisation to knock off about 0.5-1.0 percent of real GDP growth this fiscal year.
But when the dust finally settles, the economy should reap longer-term benefits insofar as demonetisation flushes out black money. For one thing, colossal amounts of money were going untaxed in an economy where less than 2 percent of citizens pay income tax. No wonder, tax-GDP ratio stands at a paltry 16 percent - far less than the emerging market average of 21 percent of GDP. Even if only a part of illicit earnings is brought under official radars, revenue will soar to new heights allowing authorities to turbo-charge the economy through higher investment in infrastructure, energy and education or bypassing on the windfall through further cuts in oil prices.
The multiplier effects are not hard to imagine. Improvements in public finance and infrastructure bottlenecks will boost sovereign rating; by extension, decrease external borrowing cost and lift foreign investment.
Another benefit accruing to the economy comes from the monetary and financial sector. Monetary transmission will most likely improve. Considering a short-term deflationary impact of demonetisation, the Reserve Bank of India will have more leeway to cut policy rates. While banks, flooded with cash deposited by citizens, can hammer down deposit rates and pass on their gains to the real economy through lower lending rates. Lower corporate borrowing costs, if neatly supported by energy and infrastructure reforms, could be the much-needed carrot that private investment in India urgently needs to spearhead economic growth in the medium and long-term.
Make no mistake; that demonetisation will inflict short-term pain is all but guaranteed. But the extent of long-term gain still remains conditional upon several factors, including (a) how much money accrues to government coffers, (b) how this money is spent, (c) whether much-needed tax reforms are put in place, and (d) the extent to which government commits to its longer-term vision of creating a society where cash plays minimal role. For now, the jury is out on how successful Modi's surgical strike will turn out to be.
The writer is a macroeconomic Research Analyst for an organisation in Washington D.C. and Research Fellow for the Asian Centre for Development in Dhaka.